European Investment Bank, Economics Department1
Abstract
1We revisit cross-border banking in Central, Eastern and Southeastern Europe (CESEE) from a historical perspective. Using information from the European Investment Bank (EIB) CESEE Bank Lending Survey (BLS), combining its results with other data sources, we demonstrate how the model of cross-border banking changed in the region after the global financial crisis. We argue that cross-border funding flows declined significantly, whilst equity exposures remained as important as before. On the one hand, international banking groups are maintaining their commitment to the region;
on the other, the decline of external funding has led to a lending strategy based on domestic funding. This strategy appears to result in more cautious – less dynamic, but also safer – credit developments in the region.
Introduction
There is a broad consensus that the economic benefits of “balanced” cross-border banking outweigh the potential costs. Cross-border banking can stabilise output through risk diversification and reduce the likelihood of bank failures and credit crunches for the same reason. It can also lead to stronger competition, faster technology transfer and more rapid spread of best banking practices, thus further enhancing financial stability. Foreign capital, however, comes at a cost. Foreign funds are likely to be more mobile than domestic ones. They can also expose the domestic economy to foreign shocks. Yet, unless it generates undue concentration, cross-border banking is
1 The views expressed in this document are those of the authors and do not necessarily reflect the position of the EIB or its shareholders.
thought to bring an overall net increase in welfare (Allen et al., 2015). Strengthening cross-border banking to reap these benefits is high on the EU political agenda: these economic benefits are a key argument supporting the Banking Union.
CESEE has often been regarded as the “poster child” of cross-border banking. The last twenty years have seen an impressive development of the banking market in the CESEE region. Starting from the mid-1990s, a process of deep transformation allowed banks to become real intermediaries of resources, with access to finance substantially increased in both the retail and the corporate sectors. A privatisation process allowed several international players to enter the region and to engage in regional growth strategies. These large players became market leaders in almost all countries in the region, carrying fresh capital and new banking practices.
Large market potential and banks’ access to funding from parents fuelled strong credit growth before 2008/9. Domestic regional demand accelerated, with both consumption and investment growing fast.
The 2008/9 crisis changed the picture. External demand collapsed and the correction of capital inflows was rather sharp, leading to negative economic growth all over the region. Concerns about potential spill-overs, via the parent/subsidiary channel, from the international financial crisis to the region increased. In this environment the Vienna Initiative has functioned as an anchor, strengthening confidence in financial markets and preserving banking activities. The European Commission and the International Monetary Fund (IMF) provided financial support to countries in need, while the European Investment Bank (EIB), European Bank for Reconstruction and Development (EBRD) and the World Bank guaranteed enhanced support to productive investment, including liquidity lines for small to medium-sized enterprise (SME) financing. At the same time, international banks active in the region committed themselves to continuing to support their subsidiaries, providing capital and funding. Ultimately, international financial institutions engaged in a Joint Action Plan. The initiative strategically contributed to preserving financial stability in the overall CESEE region. Indeed, tail risks disappeared, and fully fledged bank runs were avoided.
The recovery from the crisis was long and painful in many countries in the region.
In general, the higher the pre-crisis imbalances, the longer economic activity took to recover. Potential growth in the region has been reassessed and linked more closely to the underlying country fundamentals – i.e., productivity and export performance capacity, while nonperforming loans (NPLs) have been weighing on banks' portfolios. At the same time, the post-crisis domestic environment, the emerging changes in the regulatory environment and a reassessment of local market
opportunities have been leading to a rethinking of the operational strategies for the cross-border banks active in the CESEE region.
All in all, foreign-owned banks fostered convergence and economic growth in CESEE:
they contributed to raising living standards, supported increasing investment levels – yet also possibly generated imbalances and contagion.2 Today, the share of foreign ownership of banks in CESEE is high compared with other regions, and many subsidiary banks are also systemically important at a local level (host country).
Nevertheless, the global financial crisis brought some important lessons and changes in the nature of cross-border banking flows. First, it showed that shocks can propagate from home to host countries, possibly threatening host countries’ financial stability. Second, the experience of the crisis triggered a re-evaluation of the strategies of international banks towards the region. Some financial institutions left the region altogether, while those who stayed changed their strategies. Third, credit flows in the CESEE region in the aftermath of the crisis stalled for an extended period between 2011 and 2015. While positive credit developments resumed subsequently, lending growth has remained at a lower level than ten years before. This may represent an impediment to medium-term economic performance. Therefore, understanding the determinants of credit growth and fundamental credit market conditions is key for effective policy actions.
Against this backdrop, we revisit the state of cross-border banking in CESEE ten years after the crisis. We attempt to identify how the nature of cross-border banking has been changing, and whether these changes had an impact on aggregate credit developments (and if so, how). First, we sketch the key developments in cross-border lending. Then we describe international banks’ attitudes and positioning in the CESEE region using the EIB CESEE Bank Lending Survey.3 Next we deal with credit development and the fundamental factors behind it before offering our conclusions.
2 The transmission channels between parent and subsidiary banks have been extensively investigated in several studies focusing on different geographical areas, including CESEE. The effect of parent conditions on the lending performance of subsidiaries has been thoroughly analysed. For example, the existence of internal capital markets within international banking groups (Houston and James, 1998; De Haas and Van Lelyveld, 2010; Jeon et al., 2013) was found to be a fundamental vehicle spurring growth throughout a network of subsidiaries, as well as possibly transmitting financial weaknesses. Other studies have connected lending performance to parent banks’ balance sheet positions. (e.g. Cull and Martinez Peria, 2013; Dinger, 2009; De Haas and Van Lelyveld, 2006; Jeon et al., 2013; Gattini and Zagorisiou, 2016; Temesvary and Banai, 2017).
3 In October 2012, under the umbrella of the revived Vienna Initiative 2.0, the EIB designed, and now manages, the Bank Lending Survey (BLS) for the CESEE region, to disentangle demand and supply factors as well as the underlying domestic and international components affecting lending activity in the region. Taking into account the unique nature of the regional banking sector, with a large proportion of banks being foreign-owned, the survey investigates both the strategies of international banks active in CESEE and the market conditions and market expectations as perceived by the local subsidiaries/local banks. To that end, the survey covers the major international banks operating in CESEE and their subsidiaries in the region. At the same time, to gain a full understanding of local market conditions, an effort has been made to also include in the survey the relevant domestic players in a specific local market. For more details on the survey and data please refer to the following link: http://www.eib.org/en/about/economic-research/surveys.htm